Bernstein Diamonds

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Citation: 21 J. Legal Stud. 115 1992
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OPTING OUT OF THE LEGAL SYSTEM:
EXTRALEGAL CONTRACTUAL RELATIONS
IN THE DIAMOND INDUSTRY
LISA BERNSTEIN*
1. INTRODUCTION
BUSINESS disputes arise in all industries, and the diamond industry is

no exception. Unlike the situation in many other industries, however,
diamond industry disputes are resolved not through the courts and not
by the application of legal rules announced and enforced by the state.
The diamond industry has systematically rejected state-created law. In
its place, the sophisticated traders who dominate the industry have devel-
oped an elaborate, internal set of rules, complete with distinctive institu-
tions and sanctions, to handle disputes among industry members. This
article explores the reasons that this system of private governance has
developed and endured within the diamond trade.
Section II provides a brief overview of the diamond industry. It
sketches the workings of the international diamond cartel and discusses
diamond production and valuation. Section III describes the organization
of the market for rough and polished diamonds, paying special attention
to the role of trading clubs (bourses). It focuses on the terms and structure
of transactions and details the workings of the bourse's private arbitration
system that keeps all judgments secret as long as they are promptly paid.
Section IV is the core of this article. Section IVA briefly considers why
diamond dealers need to make executory contracts; it then explains that
the diamond market also operates as an implicit loan market. Section
IVB compares the cost of entering into legally unenforceable (extralegal)
agreements to the cost of entering into legally enforceable contracts. It
* Associate Professor, Boston University School of Law. I would like to thank Steven
Shavell, Louis Kaplow, Lucian Bebchuk, and David Chamy. The John M. Olin Foundation
provided funding for this project.
[Journal of Legal Studies, vol. XXI (January 1992)]
© 1992 by The University of Chicago. All rights reserved. 0047-2530/92/2101-0002$01.50
THE JOURNAL OF LEGAL STUDIES
concludes that the transaction costs of entering into legally enforceable

agreements cannot explain diamantaires' preference for extralegal agree-
ments and suggests that the norm of "secrecy" that pervades the industry
is at least a partial explanation for diamond dealers' preference for pri-
vately enforced agreements.
Section IVC considers the characteristics of public law that make con-
tracts enforced through litigation an unattractive option. Its primary focus
is on the way courts calculate expectation damages. It argues that, if
commercial transactions in the diamond industry were governed solely
by legally enforceable contracts under which the promisee could recover
expectation damages in the event of breach, the market would be charac-
terized by frequent, inefficient breach of contract. It attributes this ineffi-
ciency to the uncertainty of recovery, the way courts calculate damages,
the time it takes to obtain ajudgment, and the fact that many diamantaires
do not have ready access to capital markets.
Although many of the shortcomings in the American legal system that
make litigation unattractive to diamond dealers are also present in most
commercial contexts, the diamond industry is unique in its ability to
create and, more important, to enforce its own system of private law.
Sections IVD and E focus on the ways the industry's organization facili-
tates the creation of strong reputational bonds, which the bourse's arbi-
tration system in turn uses to enforce its judgments. They examine two
types of reputation-bond-based extralegal contractual regimes: the homo-
geneous group regime that is generally associated with repeat transac-
tions among members of small geographically concentrated and ethnically
homogeneous groups, and the information-intermediary regime in which
technology links markets and secures the rapid and low-cost dissemina-
tion of information about reputation. Although the industry is currently
moving from a homogeneous group to an information-intermediary-based
regime, it has succeeded, at least for the time being, in creating an over-
arching system that captures the advantages of both regimes.
Section IVF explores some of the efficiency implications of reputation
bonds, relative to those created by court-imposed expectation damages.
Section IVG discusses the substantive and procedural reasons why arbi-
tration is preferred to litigation. Finally, Sections IVH and I assess the
aggregate efficiency of the system and the importance of reputation bonds
in the market as a whole. In sum, the analysis presented in Section IV
suggests that, while the damage rules adopted by the industry may lead
to some instances of inefficient breach, the system's overall success is
due, in large part, to its ability to quickly resolve disputes and enforce
judgments-results that cannot be obtained through the legal system.
Section V uses a model of arbitration and settlement to explain why
OPTING OUT OF THE LEGAL SYSTEM
most intraindustry disputes are resolved cooperatively and without re-

course to a third-party arbiter. Section VI considers the changes in the
industry that have led to the gradual introduction of legally enforceable
written contracts in certain types of diamond transactions. It also dis-
cusses the increasing influence of civil law on the terms of diamond trans-
actions and the resolution of disputes. Section VII concludes that the
diamond industry provides strong support for the hypothesis that extrale-
gal norms trump legal rules in a given market only where market partici-
pants find that keeping to the industry norms advances their own self-
interest. The private regime must be Pareto superior to the established
legal regime in order to survive.'
II. AN OVERVIEW OF DIAMOND PRODUCTION AND VALUATION
The market for rough and polished gem-quality diamonds is best under-
stood in the context of the chain of production and distribution that begins
in a pit mine and ends up in a retail jeweler's window.2 Rough diamonds
are found primarily in Africa, Australia, and the Soviet Union; they are
not notably rare. At present, 80-85 percent of the world's supply of rough
diamonds is controlled by the DeBeers Cartel. The cartel distributes its
supply of rough diamonds through four brokers. The brokers then sell
presorted boxes of diamonds to some 150-200 dealers, known as sight
holders, 3 during ten viewing sessions, or sights, held in London each
year. Most U.S. sight holders are members of the New York Diamond
Dealers Club (DDC). At a sight, a dealer is given a box of diamonds and
informed of its price. This price is nonnegotiable. If the dealer decides
not to purchase his box, he will not be invited to subsequent sights.
Consequently, a sight holder will rarely decline to purchase his box,
A similar thesis is advanced by Robert C. Ellickson, A Hypothesis of Wealth Maximiz-

ing Norms: Evidence from the Whaling Industry, 5 J. L. Econ. & Org. 83, 84 (1989), where
he explores the "hypothesis that when people are situated in a close knit group, they will
tend to develop for the ordinary run of problems norms that are wealth maximizing." For
a broader and more theoretical articulation of this thesis, see generally, John Gray, Hayek
on Liberty (2d ed. 1986), discussing Hayek's theory of spontaneous order and the "competi-
tive selection of rules and practices," particularly, "Hayek's assertion that the evolution
of culture may itself be fruitfully investigated in terms of the competition between different
traditions or practices, with a natural selection among them occurring which is at least
partly to be explained by their relative efficiency as bearers or embodiments of knowledge."
2 The markup from mine to consumer is estimated to be between 200 and 400 percent.
3 There are three kinds of sight holders: large manufacturers who cut and polish the
stones themselves, midsize rough dealers who resell the contents of their boxes to select
manufacturers, and brokers who deal in industrial diamonds. Polished stones are sold to
wholesalers and marketed through brokers, both of whom then sell to retail establishments.
although he will sometimes negotiate in advance to sell it unopened to

another dealer on a cost-plus-profit basis.
The cartel insists that the diamonds be paid for in full within seven
days of the sight. Consequently, for most sight holders, particularly those
who cut and polish the rough themselves, access to credit is essential-it
takes three-four months from the sight date for a manufacturer to sort,
cut, polish, and sell the contents of his box. Sight holders, however,
rarely have difficulty securing financing. In the diamond industry, having
a sight is considered a near guarantee of financial success. The cartel
actively monitors the decisions and activities of sight holders; if a sight
holder continues to play by the cartel's "rules," he is rewarded with a
more profitable selection of stones. Consequently, because most monitor-
ing costs are shifted to the cartel, sight holders generally have access to
bank capital.
Diamond valuation is a subjective process. The value of a rough dia-
mond depends on the value of the polished stones that can be manufac-
tured from it. Since no two diamantaires will cut a stone the same way,
the value added in the manufacturing process varies widely. Conse-
quently, when dealers value a piece of rough differently, that difference,
on which profitability turns, often reflects a real difference in the value
of the polished stones they will be able to cut from it.
In contrast, when dealers value a polished stone differently, most of
that difference will be due to their differing estimates of market demand
and to their differential skill in detecting flaws in stones. In recent years,
however, the skill factor has become less important. Although older deal-
ers continue to maintain that even polished diamonds cannot be objec-
tively graded and valued, in the late 1970s, the Gemological Institute of
America began to issue diamond grading certificates whose widespread
use made it possible for dealers with little gem expertise to enter the
market, resulting in increased competition. By creating standardized
ways of describing polished stones, grading certificates have facilitated
the flow of price information. A private diamantaire now publishes a
weekly price list with a wide international circulation. 4
As a consequence of the standardization of grading and the availability
of price lists, the market for polished diamonds has become more com-
4 Unlike a closing quotation on a typical commodities exchange, the prices recorded in the
Rapaport Diamond Report are not actual transaction prices. Rather, they are the Rapaport
Corporation's subjective calculation of the "high asking" price, generally 15-30 percent
above the actual transaction price, for various sizes and grades of polished stones. One
explanation for the markup is that it enables retailers to quote list prices to consumers who
think they are getting a bargain when they buy below it.
petitive and prices have dropped. This has reduced the profit margin of
manufacturers since retailers now have more reliable information about
what wholesalers and manufacturers have paid for stones. Manufacturers
find themselves squeezed between the price of rough fixed by the cartel
and the competitive prices in the polished market.
III. THE MARKET FOR ROUGH AND POLISHED DIAMONDS
A. The Trading Club as a Commodities and Information Exchange

The largest and most important trading club ("bourse") in the United
States is the New York Diamond Dealers Club. Its membership is com-
prised of sight holders, manufacturers, wholesalers, and brokers. Club
membership gives a dealer prestige and an important economic advan-
tage. In the diamond industry, access to a steady supply of goods is
essential to the operation of a profitable brokerage or manufacturing busi-
ness. Although it is possible to buy stones on the "open market," a
dealer who does not have access to the trading clubs-essential links in
the worldwide diamond distribution network-will be at a competitive
disadvantage. Approximately 80 percent of the rough diamonds coming
into the United States pass through the hands of a DDC member, as do
15-20 percent of the polished stones. In addition, 20-50 percent of the
transactions conducted by or on behalf of foreign or out of town dealers
5
are concluded in the club.
The New York DDC currently has 2,000 members; in most years there
is a waiting list for admission. Although requirements for membership
are strict, the main constraint on membership is space, not the inability
of dealers to meet the membership requirements.6 As a condition of mem-
5 Despite the strict limits on the number of members it accepts, the DDC tries to attract
out-of-town dealers (and nonmembers) to its trading hall. Before being admitted to the
trading hall, out-of-town dealers must be introduced by a member in good standing who
agrees to assume "full financial responsibility (guarantee) for the out of town dealer's acts
and liabilities, incurred while on the premises of the DDC." Diamond Dealers Club Bylaws
(hereinafter DDC Bylaws), Art. 17 § 2a (1980). Consequently, nonmembers who want access
to supply find it advantageous to maintain a reputation for scrupulous honesty with club
members. The out-of-town dealer must also be approved by the board of directors, pay a
fee determined by the board, and agree to adhere to all of the club's bylaws, including the
obligation to arbitrate all disputes. In return for his sponsorship, a member who introduces
an out-of-town dealer is entitled to collect a commission of 1 percent on every transaction
the out-of-town dealer consummates.
6 To be considered for membership a dealer must (1) have been in the industry for at
least two years, (2) comply with all requests for information put to him by the board of
directors, and (3) have his picture posted in the club for ten days so that members have the
opportunity to state reasons that he should not be accepted. New members are put on
bership, a dealer must sign an agreement to submit all disputes arising

from the diamond business between himself and another member to the
club's arbitration system.7 The agreement to arbitrate is binding. Unless
the club opts not to hear the case, the member may not seek redress of
his grievances in court. If he does so, he will be fined or expelled from
the club. Furthermore, since the agreement to arbitrate is binding, the
court will not hear the case.
Most large and important dealers are members of the club, but they do
not usually conduct their business in the club's trading hall. In the dia-
mond industry, where profitability depends largely on a dealer's network
of contacts, secrecy is valued; large-scale transactions tend to be consum-
mated in private offices. In addition, because properly valuing a stone
depends on the ability to detect minor flaws and color variations, buyers
prefer to examine large stones in familiar light. Furthermore, for security
reasons, many dealers do not want it known that they have valuable
stones in their possession. Larger dealers will, however, come to the
club's trading hall to get a feel for market prices. As one dealer explained,
a visit to the club enables him to "keep a finger on the pulse of the
business." Although a price list is available for certain classes of polished
stones, the bourse's trading floor is the only place to obtain a feel for
the market price of rough diamonds: standardized price information is
unavailable. Unlike other commodities exchanges, the DDC itself does
not record either actual transactions prices or the volume of transac-
tions.'
Smaller dealers, brokers, and foreigners do most of their trading in the
club. For them, club membership provides a secure trading place at a
modest cost with additional informational benefits. In general, the reputa-
tions of smaller dealers are less well established. Club membership en-
probation for a period of two years during which "the Board of Directors reserves the right
to terminate such membership at any time within this period for any reason." Id. at Art. 3
§ 8. New members are charged a $5,000 initiation fee, and annual dues are $1,000.
Although corporations may designate individuals to become members of the club and to
trade on their behalf, these individuals do not enjoy limited liability as they would under
the civil law. See Diamond Dealers Club Arbitration Bylaws (hereinafter DDC Arbitration
Bylaws), Art. 12 § 25 (1987). The corporation or partnership is also considered liable and
bound by the members' agreement to submit all disputes to the DDC arbitration system.
DDC Bylaws, Art. 3 § 2b.
The traditional view of diamond trading as a family business is reflected in the member-
ship bylaws: more lenient rules govern the admission of sons, daughters, sons-in-law, and
daughters-in-law. For example, id. at Art. 3 § 2a, provides that widows of members are
automatically accepted and do not have to pay an initiation fee. Similarly, the "wife of an
incapacitated member may be accorded entry into the Club at the sole discretion of the
Board of Directors until her husband becomes active." Id. at Art. 3 § 3b.
7 See id. at Art. 12 § lc.
8 The Federal Trade Commission estimates that 700-800 dealers use the club each
day.
ables them to signal that they are trustworthy and, conversely, gives
them the assurance that all the dealers in the trading hall have fulfilled the
requirements for club membership, an important non-transaction-specific
piece of information.
The bourse is an information exchange as much as it is a commodities
exchange. As one author put it, "the bourse grapevine is the best in the
world. It has been going for years and moves with the efficiency of a
satellite communications network. . . .Bourses are the fountainhead of
this information and from them it is passed out along the tentacles that
stretch around the world." 9 The bourse facilitates the transmission of
information about dealers' reputations ° and, at least with respect to
members, serves both a reputation-signaling and a reputation-monitoring
function. "
The New York DDC is a member of the World Federation of Diamond
Bourses (WFDB), an umbrella organization composed of the world's
twenty diamond bourses. 2 A dealer who is a member of any one bourse
in the world federation is automatically allowed to trade at all member
bourses. Each bourse has similar trade rules, and, like the individual
bourses, the WFDB has an arbitration system to resolve differences be-
tween its members. As a condition of membership in the federation, each
bourse is required to enforce the arbitration judgments of other member
bourses to the extent permitted by the law of the country in which it
operates. 13
B. The Standard Transactional Paradigm

In the diamond industry, a handshake accompanied by the words mazel
u'broche creates a binding agreement. Section One of the Trade Rules
9 V. Berquem, Bourses More than a Place to Sell, Jewellery News Asia (August 1988).
to For example, the DDC's bulletin boards carry letters from dealers who feel they have
been victimized by baseless gossip. These letters contain rebuttals and frequently include
strong language condemning the integrity of dealers who spread baseless rumors. Some-
times, in addition to being posted, such letters are distributed in the trading hall or on
Forty-seventh Street itself.
11As stated in its bylaws, the purposes of the club are, among other things, "to inculcate
just and equitable principles in trade, to eliminate abuses and unfair trade practices relative
thereto or affecting the same, to diffuse accurate and reliable information concerning the
matters relating thereto, [and] to produce uniformity in the conduct of business ethics."
DDC Bylaws, Art. 2.
12 The DeBeers Cartel does not control the WFDB. One of the main reasons the WFDB
was formed was to enable the bourses to bargain more effectively with the cartel. See,
generally, Albert Lubin, Diamond Dealers Club: A Fifty Year History (1982).
"3For more information on the rules of the World Federation, see World Federation of
Diamond Bourses: Bye-Laws and Inner Rules (unpublished report, World Federation
of Diamond Bourses, November 15, 1988).
provides: "[a]ny oral offer is binding among dealers, when agreement is

expressed by the accepted words 'Mazel and Broche' or any other words
expressing the words of accord." 14 While older dealers continue to ad-
here to this tradition in a steadfast manner, younger dealers who tend to
be less well acquainted with their trading partners and more worried
about the prospect of misunderstanding or breach often memorialize the
key terms in writing, despite the fact that such a writing is not required
for formation of a binding agreement.
The most common transactional paradigm is known as "open ca-
chet." 15 When a buyer makes an offer to a seller or a broker, the stone
is put in an envelope which is then folded and sealed in a precise way.
The terms and conditions of the offer are placed on the envelope as is the
date. The buyer then signs the parcel across the seal. Unless otherwise
specified, this offer is considered binding on the offerer until one o'clock
the next day. The seller may accept at any time during this period by
contacting the buyer and saying "mazel and broche." If, however, the
seller either rejects the offer or makes a counteroffer during this period,
his option to accept the buyer's original offer is canceled.
There are sound business reasons for the use of written terms on a
cachet parcel. If the buyer who made the offer and created the binding
option contact cannot be reached by a seller who wants to accept the
offer within the proscribed period of time, the seller, assuming that he is
a member of the club, is entitled to "place his acceptance of the offer,
in writing, on the same wrapper and have the time of his acceptance
certified by a member of the Board of Directors of the Diamond Dealers
Club." 6 Without this formality and its attendant trade rule, a buyer who
regretted making an offer could simply refuse to see visitors or take phone
calls until the cachet period had elapsed. A buyer's reachability is difficult
and costly to monitor given the variety of plausible excuses that could
be invented. Thus, a more explicit form of contract is used to overcome
the weakness of the reputation bond. Finally, in open cachet transactions
14 DDC Bylaws, Art. 18 § 1.

'5 Another type of cachet used less frequently than open cachet is known as a "Zee'ch,"
or "search" cachet. In a Zee'ch transaction, the seller seals the stone and signs the parcel.
This signals his agreement not to show the stone to anybody else for a period of twenty-four
hours. A Zee'ch seal does not give the buyer an option to purchase the sealed stone at a
particular price. Rather, it gives him an exclusive right to resume negotiations for the stone
at a specified time in the future. It is common for buyers to shop around by putting a variety
of stones under Zee'ch. This practice makes sense in the market for rough stones where
no standardized price information is available; it makes comparison shopping easier, which
facilitates competitive pricing.
16 DDC Bylaws, Art. 18 § 3.
there is generally no such thing as opportunistic breach by a seller. Al-

though it is improper for the seller to show the stone to another buyer
while it is still under cachet, the wrapper is signed across the seal to
discourage this and make its violation known to the buyer. Nonetheless,
if the seller receives a higher offer on the stone from someone who viewed
it prior to consummation of the cachet, the trade rules permit him to
terminate the cachet by contacting the original cachet holder. It is cus-
tomary, however, for him to tell the original buyer of the new offer and
to give him the opportunity to match it. This leads to a miniauction with
the stone being sold to the highest bidder.
Although the cachet is formally an agreement between a buyer and a
seller, its most important function in the market is to regulate the relation-
ship between a seller and his broker. If no cachet were used and the
buyer offered five hundred dollars per karat for the stone, the broker
might tell the seller that the buyer offered four hundred dollars per karat.
If the seller accepted, the broker would pocket the difference. This is not
the type of dishonest behavior that could be easily monitored and en-
forced through reputation bonds since detection and a determination of
the precise circumstances would be difficult.
When a deal is physically concluded on the floor of the DDC, a docu-
ment akin to an integrated writing is frequently, but not always, pro-
duced. After the parties have either made an oral agreement or gone
through the formalities of cachet-that is, at a stage in the transaction
where the parties already consider themselves bound-they take the
goods to be weighed by a club employee who issues them an official
weight slip. The slip is then signed by the person who gave the stone to
the club official, most commonly, though not exclusively, the buyer, and
the terms of payment and the price are added. If the sale was concluded
in accordance with the rule of open cachet, the cachet parcel is included
in the bag with the stone and the official weight slip. Only one copy of
the slip exists, and it is retained by the seller. If a dispute later occurs,
the club's dispute resolution bodies consider the slip to be definitive evi-
dence of both the stone's weight and the existence of the transaction.
In some instances, stones are traded not on the floor of the DDC but
in private offices. In this case, a standard bill of sale is drawn up when
the deal is concluded and before the buyer leaves with the stones. Fre-
quently, however, it is sent by the seller after the buyer has left with the
stone but before he has paid in full. Dealers explain that when they really
trust the person they are trading with they do not, at the time of "con-
tracting," attach any real importance to this writing. Traditionally, the
bill of sale has been viewed as a mere formality used primarily for ac-
counting purposes.
Even if either the weight slip or the bill of sale satisfied the require-
ments of the New York Statute of Frauds, a suit could not be brought in
either New York State Court or federal court since the club membership
agreement requires that all disputes between club members be arbitrated,
and this agreement has been upheld as binding.
C. The Club's Private Arbitration System

Around 150 disputes per year are submitted to the DDC's arbitration
system. Of these, an estimated 85 percent are settled during the manda-
tory prearbitration conciliation procedure. Although there has been a
slight increase in the number of arbitrations in recent years, this is attrib-
uted primarily to the increase in club membership and not to a deteriora-
tion of trade ethics.
The DDC's procedural rules clearly reflect the industry's preference
for the voluntary resolution of disputes. The bylaws are structured to
give the parties control over the dispute resolution process and to create
financial incentives to settle. For example, prior to an arbitration hearing,
the parties are required to participate in a conciliation proceeding, and
"whenever an adjustment by conciliation is consummated, the chairman
of [the three-person conciliation] panel may refund the arbitration fee or
any part of the same." 17
An important feature of the arbitration system is the secrecy of the
proceedings. The arbitrators are not required to make findings of fact and
do not produce written decisions explaining their reasoning. As long as
judgments are complied with, the fact of the arbitration as well as its
outcome are officially kept secret.
ProceduralAspects of Arbitration. There are two dispute resolution
bodies in the DDC, the Floor Committee and the Board of Arbitrators;
both are composed of club members elected for two-year-terms. Before
a dispute is referred to arbitration, the Floor Committee must find that a
material issue of fact exists. The standard used is similar to the familiar
standard for granting summary judgment.
The Floor Committee has the authority to exclude a member from the
trading hall for up to twenty days and/or impose a fine of up to $1,000
when the member "fails to meet his commercial obligations to another
member and no material issue of fact is involved or a member causes a
disturbance or conducts himself in the clubrooms in a manner unbecom-
ing a member of the club." 18 A decision of the Floor Committee may be
17 DDC Arbitration Bylaws, Art. 12 § 8.

8 Id. at Art. 8 § 7B .
appealed by filing a written request and paying the $100 appeal fee. Un-
less the panel finds that a material issue of fact exists and recommends
that the case be referred to arbitration, the decision of the appeal panel
is final. Neither the Floor Committee nor the appeal panel are required
to make any findings of fact.
Any member of the DDC who has a claim "arising out of or related to
the diamond business" 1 9 against another member has the right to file a
written complaint against the member who must then submit to DDC
adjudication. At the time he files the complaint, the plaintiff must pay a
small arbitration fee,2" but at the conclusion of the case the panel "shall
decide which of the litigants shall pay the arbitration fee and the expenses
which were necessarily incurred, and . . . may refund the arbitration fee
or any part of it." 2 Arbitrators are required to render their decision
within ten days of the hearing.
Arbitration awards can be appealed if notice of appeal is filed with the
board of directors within ten days of the parties' receipt of the judgment.
The appellant must pay a fee three times the original arbitration fee and
"deposit cash or sufficient security to cover the amount of the judg-
ment." 22 The appeals board is composed of five arbitrators who did not
hear the original case, and it too is "under no obligation to specify any
findings of fact which are reversed or modified nor set forth any new
findings of fact." 2 3
The decisions of the arbitration board can be appealed to New York
State court under New York law, but arbitration awards can only be
vacated for procedural irregularities, such as an arbitrator engaging in an
ex parte communication or a failure to allow the parties to be represented
by counsel.2" The substantive rule of decision is not reviewed.
'9 Id. at Art. 12 § Ia.

20 Id. at Art. 12 § 2.
21 Id.
22 Id. at Art. 12 § 15.
23 Id. at Art. 12 § 17.
24 See, for example, Goldfinger v. Lisker, 508 N.Y.S.2d 159 (on a motion to confirm a
DDC arbitration award the court granted a cross motion to vacate the award on the grounds
that, while the DDC Bylaws do authorize arbitrators to investigate the facts, ex parte
communications with arbitrators are not thereby sanctioned). In addition, New York law
requires that the arbitration process be free from the appearance of bias. See, for example,
Rabinowitz v. Olewski, 100 A.D.2d 539; 473 N.Y.2d 232 (2d Dept 1984) (where the court
ordered a stay of DDC arbitration and directed that the case be heard by an independent
arbitrator after a letter surfaced in the club accusing the plaintiff of being sympathetic to
the Palestine Liberation Organization; since it was clear that a substantial injustice might
result were the case heard by the predominantly Jewish DDC and there was the "appearance
of impropriety and specter of bias among the DDC").
Although the DDC arbitration system is operated primarily for the ben-
efit of club members, nonmembers who have a dispute with members
often request that the club hear their case. In most instances, the board
will grant their request as long as the member consents and both parties
sign an agreement to arbitrate. There are a number of reasons why non-
members might request that the DDC arbitrate a dispute with a member.
First, if the nonmember knows he is in the wrong, yet the parties are
unable to agree on a settlement, then having a neutral third party assess
a penalty should enable him to minimize the reputation cost of his breach
since arbitration awards are kept secret if the judgment is paid promptly.
Although the arbitration's results sometimes become known through gos-
sip, as long as the individual is not frequently involved in such controver-
sies, the damage to his reputation is likely to be contained. Second, if the
nonmember thinks he is in the right, arbitration is preferable to litigation
because it is cheaper, faster, and subjects the member to unqiue pressures
to pay promptly. Although club members are not obligated to submit
disputes with nonmembers to arbitration, they will often agree to do so
in order to avoid the transaction and reputation costs of going to court.
Substantive Aspects of Arbitration. The DDC Board of Arbitrators
does not apply the New York law of contract and damages, rather it
resolves disputes on the basis of trade customs and usages. Many of
these are set forth with particularity in the club's bylaws, and others
simply are generally known and accepted. Although at first glance dia-
mond transactions appear to be simple buy-sell agreements, complicated
controversies often arise, particularly in the sale of polished stones. In
general, disputes fall into three main classes: those that have explicit
remedies prescribed in the trade rules; 5 those that have no explicit reme-
dies prescribed but are common enough that they are dealt with consis-
tently according to widely known customs; and those complex disputes
that the arbitrators either decline to hear or decide in accordance with
rules of decision and damage measures that neither party can predict ex
ante.
The dispute resolution system in the diamond industry shows some
sensitivity to concerns of institutional competence. Under its bylaws, the
club has the right to refuse to arbitrate a claim when it does not arise out
of the diamond business, or "(1) involves complicated statutory rights;
(2) is 'forum nonconveniens' in that it is burdensome or inconvenient
to handle the claim in the Club; (3) involves nonmembers; (4) has been
25 See DDC Bylaws, Trade Rules II: Customs and Usage. For the rules governing transac-
tions in certificate stones, see DDC Arbitration Bylaws, Trade Rules Regarding Certificate
Stones.
conciliated, mediated, arbitrated or litigated outside the Club and/or the

parties have sought remedies elsewhere; (5) is not in the ordinary course
of commercial dealings." 26 When the club refuses to hear a case, the
parties are permitted to seek remedies outside the club.
In complex cases that are neither explicitly covered by the trade rules
nor dealt with according to established custom, it is difficult to determine
what substantive rules of decision are applied. Arbitrators explain that
they decide complex cases on the basis of trade custom and usage, a little
common sense, some Jewish law, and, last, common-law legal principles.
There are no general rules of damages. When calculating damages, the
arbitrators look at the stone, consider the circumstances, and apply their
business experience. Many dealers feel that the arbitrators have redistrib-
utive instincts; they cite the unpredictability of the decisions as well as
the arbitrators' tendency to "split the difference" as an important motiva-
tion to settle their disputes on their own. This may be a reason why,
while 150 arbitration complaints are filed each year, only thirty to forty
go to judgment. The arbitrators announce their judgment, but they neither
make findings of fact nor explain their reasoning. The absence of explicit
findings of fact and written opinions is a precaution to prevent people
from complaining, rightly or wrongly, that the arbitrators were biased,
unfair, or relied on evidence that lacked probative value. The arbitration
board is like a jury black box. Diamond dealers eschew arbitration for
many of the same reasons that businessmen in general are wary of jury
trials, primarily the uncertainty of the outcome.
A person who is found to have breached an agreement or engaged in
unethical conduct is sometimes ordered to pay punitive damages or a fine
in the form of a donation to charity in addition to compensating the other
party for his loss. Thus, unlike court awards that, while unpredictable,
are at least bounded by expectation damages, arbitration awards have a
completely uncertain component. In one case, a dealer falsely accused
another dealer of stealing a stone. The accuser subsequently remembered
where he had put the stone and apologized to the other dealer. As the
incident had become widely known throughout the club, however, the
wrongly accused dealer brought an arbitration action against the owner
of the stone for impugning his good name. The board ordered the man to
make a full public apology and a fifty thousand dollar donation to a Jewish
charity.
26 Id. at 12 § lb. See, for example, Finker v. The Diamond Registry, 469 F. Supp. 674
(S.D.N.Y. 1979) (where the DDC agreed to decide issues concerning the ownership of
goods held on memorandum (consignment) but "refused to involve itself in the dispute
concerning the trademark registration and alleged infringement").
Enforcing Arbitration Judgments. The DDC Bylaws provide that

"[a]ll decisions of arbitration panels including floor committee arbitra-
tions which are not complied with within 10 working days, together with
the picture of the non-complying member, shall be posted in a conspicu-
ous place in the Club rooms." 27 This information is communicated to all
bourses in the world federation. As a condition of membership in the
federation, each bourse agrees to enforce the judgments of all member
bourses. Since most diamond dealers frequently transact in foreign
bourses, this reciprocity of enforcement greatly increases the penalty for
failing to voluntarily comply with an arbitration judgment.
The arbitration board can also suspend or expel a member for failing
to pay a judgment or failing to pay his diamond-related creditors without
making special arrangements through the club's private bankruptcy sys-
tem.28 Unlike the arbitration system, which operates in place of a public
trial, the DDC's bankruptcy rules and procedures do not supplant civil
bankruptcy law; they provide instead a parallel set of rules that are man-
datory for club members: "[a]ny settlements made outside of the jurisdic-
tion of the Club do not absolve the debtor member's liability for suspen-
sion purposes." 29 There is no such thing as "discharge" under the private
bankruptcy rules: "All debtors must make provisions for the payment of
one hundred percent (100%) of his/her debt"; 3" debt is rescheduled on
the basis of the dealer's ability to pay.
After the club has been notified of a member's bankruptcy, the member
is required to "turn over in escrow to the Diamond Dealers Club, Inc.
his assets of any kind for distribution to his creditors,"'" and a creditors
committee is formed to effect the distribution. While bankruptcy proceed-
ings are taking place, the debtor is not allowed to enter the club room
32
unless given explicit permission to do so by the club committee. Simi-
larly, "where the debtor has requested a settlement with his creditors for
any sum less than one hundred percent (100%), and has not complied
27DDC Arbitration Bylaws, Art. 12 § 26.

2 See, generally, DDC Bylaws, Art. 20.
29 Id., Art. 20 § 18. In addition, a member is automatically suspended from the club for
"filing a petition in bankruptcy or any involuntary petition in bankruptcy, [or] making an
assignment for the benefit of creditors." DDC Arbitration Bylaws, Art. 7 § I.
30DDC Bylaws, Art. 20 § 18.
31Id. at Art. 20 § 2a.
32 See, for example, Matter of Marcus [MVAIC], 29 Misc.2d. 573, In Matter of Paul
Verstandig v. Diamond Dealers Club, Inc. 23 A.D.2d 547 (1965) (upholding "the Club's
action in suspending petitioner as a member for the breach of the Debtor-Creditor General
Rules of the Club").
with the action required of him as set forth in this article," ' 33 he may be
suspended or expelled from the club and his name is circulated to all of
the bourses in the world federation and posted on their bulletin boards.
The bankruptcy rules are strictly enforced since the industry depends on
credit reliability.
After conclusion of bankruptcy proceedings, "[a] majority of the Board
of Directors may reinstate any suspended member should they feel s/he
has conducted her/himself as a bona fide debtor and has made provisions
for the payment of one hundred percent (100%) of his/her debt." ' 34 For-
merly bankrupt members who comply with the club's bankruptcy rules
are sometimes readmitted under this provision.
In general, the Board of Arbitrators uses suspension more frequently
than expulsion to secure compliance with its decisions. Expulsion pre-
sents a classic end-game problem. The expelled member may feel like
he has nothing to loose by challening the club-he can try to upset the
board's decision in court, file a private antitrust suit, or sue in tort for
interference with business relations. The bylaws, however, provide that
a member who was suspended or expelled may be readmitted after two
years on the same terms as a new member. Although this provision ap-
pears to be a partial solution to the end-game problem, due to the long
waiting list of those already qualified for club membership and the subjec-
tivity of the admissions process, dealers are not routinely readmitted
under this provision. Furthermore, even if the admissions committee
voted to readmit a dealer, his ability to avoid being shunned would de-
pend on the original reason for his expulsion. The bylaw provision was
probably included to enable the club to avoid charges of intentional inter-
35
ference with business relations.
Under New York law, binding arbitration awards can be confirmed in
civil court. If this is done, the judgment has the same force and effect as
an initial court award. In practice, however, it is rarely necessary for a
party to a DDC arbitration to seek confirmation of a judgment. While
arbitration awards are officially kept secret, a confirmation proceeding in
court would quickly become public knowledge. Thus, the dealer against
whom the judgment was entered would suffer severe damage to his repu-
tation. Furthermore, if a member refuses to pay a judgment and the party
33DDC Bylaws, Art. 20 § I Ia.

34Id. at Art. 20 § 19.
35In the wake of an antitrust suit brought against the club in 1951, challenging the club's
practice of refusing to deal with Germans after World World II, an article was added to the
bylaws that cautions members not to engage in any behavior that can be construed as being
in restraint of trade.
who prevailed finds it necessary to obtain a court enforcement order, the

DDC bylaws require the losing party to pay an additional 15 percent of
the award to cover his opponent's legal expenses. Another enforcement
mechanism sometimes invoked by the arbitrators is a proceeding in Jew-
ish rabbinical courts against the party who refuses to comply. Because
these courts have the authority to ban an individual from participation in
the Jewish community, this is a powerful threat against Orthodox mem-
bers of the diamond industry.
IV. AN ECONOMIC ANALYSIS OF THE EXTRALEGAL CONTRACTUAL REGIME
A. The Reasons That Executory Agreements Are Needed

In order to understand contractual relations in the diamond industry,
it is important to briefly consider why executory agreements-con-
tracts-are used at all. For many transactions, simultaneous exchange
is advantageous. It reduces the riskiness of the transaction, decreases
transaction costs by eliminating costly and time consuming negotiations
over payment terms, eliminates the need for going through the formalities
of cachet, and, most important, enables dealers to trade with people
about whose reputation they have little information. Simultaneous ex-
change is facilitated by the presence of a major diamond-financing bank
in the same building as the DDC. In addition, the seven other banks that
extend credit to New York dealers are located nearby.
Although simultaneous exchange frequently occurs, particularly in
small-scale transactions, it is neither possible nor beneficial in many in-
stances. There is a great need for credit in the diamond industry. As
explained above, even the largest sight holders need credit to finance the
purchase of their boxes of rough. Similarly, non-sight holders also ac-
quire most of their stones on a cycle that follows, but lags behind, the
schedule of sights. They therefore need credit to enable them to purchase
enough stones to keep their cutters working until the next sight. Access
to credit is also essential in the market for polished stones. Because
polished stone sales are highly seasonal, with 30-40 percent occurring in
November and December, access to credit is needed to avoid a cash
shortfall.
After the diamond crash of the early 1980s, 36 banks became more reluc-
36 As a result of a confluence of factors, the diamond industry suffered a severe crash in

the late 1980s. Throughout the mid- to late 1970s, the Israeli banks began extending low
interest rate loans to rough dealers at the direction of the Israeli government, who wanted
to expand the diamond cutting industry in Tel Aviv. The only collateral required was the
tant to finance diamond dealers, particularly small dealers and non-sight

holder manufacturers. As a consequence, bargaining over the term of
payment became an important and contentious stage in contract negotia-
tion. The most common terms are immediate cash payment, thirty-day
terms, and sixty-day terms. The thirty- and sixty-day periods correspond
roughly to the time it takes to manufacture a stone. This varies depending
on the cut, the stone, and the skill of the manufacturer. The close correla-
tion between cutting time and the length of the payment terms suggests
that sellers generally finance most, if not all, of the buyer's (manufac-
turer's) cash gap.
The market for rough and polished diamonds functions not only as a
commodities market but also as an implicit capital market. 37 One possible
explanation for the extension of credit by sellers is that sellers typically
have better and less expensive access to outside capital than most buyers.
Many of the important sellers are also DeBeers sight holders. The fact
that a dealer is a sight holder sends a signal to the bank that he is a good
credit risk. Banks prefer to lend to sight holders because they need not
incur the large cost of valuing gems that they would have to bear if they
lent to non-sight holders whose inventories are in a constant state of
flux. Lenders can offer lower interest rates to sight holders because they
can have greater confidence when they make loans and most monitoring
costs are shifted to the cartel.
Unlike banks, sight holders are industry insiders; they have good infor-
mation about individual dealers' reputations and transact with the same
people on a repeat basis over a long period of time. It is thus cheaper for
sight holders to monitor dealers' reputations and credit worthiness than
it is for banks. Consequently, it is likely that sight holders can offer terms
diamonds actually purchased, which were stored in the banks' vaults. When the world
economy entered a recession in 1980, dealers found it difficult to resell their diamonds and,
as the price began to fall, they defaulted on loans. The banks found themselves with a 1.5
billion dollar stockpile of diamonds, more than the DeBeer's Cartel could afford to re-
purchase to maintain the price. Although an agreement between the cartel, the Israeli
government, and the Israeli banks was finally reached that prevented the entire stockpile
from being immediately released into the market, enough were resold to drastically lower
prices.
At around the same time the "investment diamonds" scheme that had been developed
in the late 1970s, whereby telephone salesmen sold sealed packages of "investment" grade
diamonds to investors along with a promise to repurchase them at a later date, also went
bust when the companies failed and purchasers tried to cut their losses by selling the
diamonds on the open market, further depressing prices.
"7 In addition to the sale of goods on credit, the practice of giving goods on consignment
(memorandum), which is common in transactions between wholesalers and retailers, is a
way of effecting an implicit loan.
(and an implicit interest rate) that a buyer would prefer to simultaneous

exchange financed through a short-term bank loan.38
The economics of the diamond industry suggest that there must be a
way for dealers to make and enforce executory contracts. Sections IVB
through E discuss why the diamond industry opts for extralegal agree-
ments over legally enforceable contracts and considers the two ways that
these extralegal agreements are enforced. Sections IVF through I con-
sider the efficiency implications of these arrangements and discuss the
substantive and procedural reasons that arbitration is preferred to liti-
gation.
B. The Choice between Extralegal Agreements and

Legally Enforceable Contracts
One line of analysis used to explain market transactors' choice between
legally enforceable contracts and extralegal contracts focuses on the
transaction costs of negotiating and drafting legally enforceable agree-
ments. It is not clear, however, a priori that these costs are necessarily
higher than those incurred in the formation of an extralegal contract con-
summated with a handshake. Because the ability of the promisee to en-
force an extralegal contract depends on the posting of a reputation bond
by the promisor, each of the parties must bear the "information cost" of
determining whether the other party is trustworthy before negotiation
over the terms of the agreement even begins.39 This cost may be substan-
tial and will depend, at least in part, on the size, structure, and terms of
the proposed transaction as well as on the likelihood that the parties will
have occasion to deal with one another again in the near future.
38 The Merchants Bank of New York, however, is attempting to create a market niche
for itself by creating a special group of gem experts who become involved in the day-to-day
operations of the industry (thereby gaining access to intraindustry reputation information).
The bank then extends short-term loans to non-sight holder dealers. The bank's policy,
however, is new and it is too early to assess its success.
" Although in the typical diamond transaction the buyer takes possession of the stone
and promises to pay the seller at some time in the future, the buyer must still obtain
information about the seller's reputation. Using lasers and chemical processes, diamonds
can be treated to artificially enhance color and disguise flaws. Small flaws and differences
in color dramatically affect the value of a stone. Many of these "treatments," however,
cannot be detected without sophisticated equipment. Although in theory buyers could have
every stone evaluated by a gemological laboratory to determine whether or not it had been
altered, this would be prohibitively time consuming and expensive. Nevertheless, if a dealer
purchases a "treated stone" and sells it to someone else who discovers the stone's treat-
ment, he can be taken to the arbitration panel for failing to disclose the treatment. The
panel must then decide whether the dealer knew or reasonably should have known of the
stone's treatment. The reputation of the person he purchased the stone from is an important
factor considered by the arbitrators. See also note 64 infra.
In general, the magnitude of precontract transaction costs incurred in

the formation of extralegal contracts will depend on how common such
contracts are in the relevant market. In the diamond industry, extralegal
contracts are the dominant contractual paradigm. Consequently, the in-
dustry is organized to minimize the cost of obtaining information about
dealers' reputations.
In addition to the bourse system, which rapidly transmits reputation
information, the precontract transaction cost of entering into an extrale-
gal contract is reduced by the use of brokers. Brokers are able to gather
information about individuals' reputations for trustworthiness at a lower
effective cost than individual buyers and sellers because a broker's in-
vestment is less transaction specific. When a buyer and a seller invest in
acquiring information about their respective reputations only to find that
the buyer needs a particular size stone that the seller does not have, the
parties have lost part of their investment. While the information acquired
may be useful to them in the future, its value diminishes over time as its
accuracy decreases. In contrast, a broker who has this information can
shop around immediately for new trading partners for either party. As
the geographical dispersion of the industry increases, brokers are becom-
ing more important.4"
In a market where enforcement depends on social ostracism or reputa-
tional damage, the formation of an extralegal contract depends on infor-
mation about reputation. In addition, it requires adherence to enough
formalities to alert other members of the relevant group that an agreement
has taken place. In the diamond industry this function is served by cus-
toms such as handshakes, cachets, weight slips, and bills of sale that
are able to effectively serve the channeling, cautionary, and evidentiary
functions of formality while imposing minimal additional cost. 4
'0Despite their informational advantage, there are a variety of factors that limit brokers'
role in the market. Information about "trustworthiness," unlike consumer credit informa-
tion, is difficult to communicate in objective terms. What is ethical behavior to a thirty-
year-old dealer, may be an abhorrent business practice to a sixty-year-old dealer. (One
Israeli dealer explained that within the bourse there are small trading groups whose mem-
bers trade primarily among themselves. The groups are defined by their standards of what
constitutes fair and ethical trading.) In addition, even when they participate in brokered
transactions, the individual buyer and seller still have to acquire some information about the
broker's judgment and reputation. This task is cheaper, however, since it is less transaction
specific. Once a dealer determines that a broker has good judgment, he has access to many
other dealers whose reputations he need not inquire into directly. Even so, the brokerage
fee of 1 percent of the price may be prohibitively high, particularly on low-profit-margin
transactions.
41 See Lon Fuller, Consideration and Form, 41 Colum. L. Rev. 799 (1941) (distinguishing
between: (1) the channeling function of contract in which "form offers a legal framework
into which the party may fit his actions .... it offers channels for the legally effective
The diamond industry's preference for an extralegal contractual regime

cannot be explained by the transactions costs incurred in preserving an
agreement in an integrated writing. Although the industry is organized to
minimize the costs of using extralegal agreements, given the widespread
use of weight slips, invoices, and bills of sale, the additional transaction
costs of using legally enforceable standard-form contracts would not be
significant. These agreements could be drafted to approach a complete
contingent-state contract because most of the events that might disrupt
a transaction are well known within the industry and are subject to well-
established customs and usages within the trade. Nonetheless, the use of
such agreements is not observed.
In the diamond industry, even if fully specified legally enforceable con-
tracts were widely used and could be inexpensively drafted, dealers
would still incur many of the precontract transaction costs of entering
into extralegal agreements. In general, as the cost of enforcing a contract
in court increases relative to the expected benefit, even fully specified
legally enforceable contracts contain an implicit and increasingly large
extralegal component. This is also true when the expected value of the
court-awarded remedy is insufficient to fully compensate the promisee.
In the typical diamond transaction, litigation costs would be high relative
to the amount that could be recovered, and the promisee would almost
always be undercompensated under standard damage remedies.42 There-
fore, even if legally enforceable contracts were used, diamond dealers
would still need the benefit of the reputation bond posted in the formation
of an extralegal agreement. And, consequently, dealers would still have
to incur the transaction costs of inquiring into their trading partner's
reputation and conforming to industry custom.
In addition, a legally enforceable agreement, no matter how cheap to
draft and easy to enforce, is not usually considered to be a positive
"good" in the diamond industry. Secrecy is highly valued,43 and whoever
makes public the workings of the business will suffer a loss in the value of
his reputation, even if he is merely defending himself against a meritless
lawsuit. Consequently, individual traders, fearful of litigation that might
reveal trade practices, prefer to conclude transactions using agreements
expression of intention"; (2) the "cautionary or deterrent function by acting as a check

against inconsiderate action"; and (3) the evidentiary function "of providing evidence of
the existence and purpose of the contracts in the case of controversy").
42 See text at Section IVC infra.
43 From the perspective of insiders, secrecy raises high barriers to entry that reduce
potential competition. Secrecy also helps ward off unwanted government regulation of the
market.
that are enforceable only in the bourse's arbitration tribunals, where the
existence and outcome of a dispute are kept secret as long as the judg-
ment is paid promptly. Given the well-established institutional premium
on secrecy, parties are rarely willing to pay the reputational price of
violating that norm simply to gain access to the courts. Historically, pre-
serving the secrecy norm is one of the primary reasons that the industry
uses extralegal agreements rather than legally enforceable contracts.
Although the secrecy norm's strength has been diminishing in recent
years, the industry's preference for extralegal contracts remains strong.
In general, parties are more likely to opt for extralegal contracts when-
ever there are costs or factors that the courts are systematically unwilling
to recognize or take into account in setting damages (either for doctrinal
or public policy reasons) but that ex ante both parties perceive as being
important." The same is also true when the courts refuse to apply a rule
of decision preferred by the parties or, in interpreting agreements, refuse
to do so in light of the prevailing custom. In sum, extralegal contracts
are more likely to become an industry norm in situations where traditional
contract remedies are likely to lead to inefficiently high levels of breach
of contract and the market is organized in a way that makes other meth-
ods of enforcing these agreements possible. In the diamond industry,
both of these conditions are met.
C. The Shortcomings in the American Legal System and

the Common Law of Damages That Make Extralegal
Contracts Desirable to Diamond Dealers
If commercial transactions in the industry were governed solely by
explicit, legally enforceable contracts under which the promisee could
recover expectation damages in the event of breach, the market would
be characterized by frequent inefficient breach of contract. The sources
of this inefficiency are the uncertainty of recovery, the way courts calcu-
late damages, the length of time it takes to obtain a judgment, and, in
some instances, the fact that many diamantaires do not have ready access
to capital markets. In most settings, expectation damages, as enforced
through the courts, do not achieve their stated theoretical objective of
placing the promisee in the same position that he would have been in if
the breach had never occurred; they neither make the promisee whole
ex post, nor give the promisor sufficient incentive to perform the promise
ex ante.
I A similar argument is advanced by Richard A. Epstein, Beyond Forseeability: Conse-

quential Damages in the Law of Contract, 18 J. Legal Stud. 112-13 (1989).
In practice, courts are reluctant to award compensation for lost profit

since in most instances it is considered speculative. In a diamond transac-
tion, when a seller fails to deliver a stone, lost profit is extraordinarily
difficult to calculate since it is highly idiosyncratic." A dealer's profit on
a rough stone depends intimately on his network of contacts, his skill as
a cutter, and his ability to choose a cut for which market demand is high.
The same is true of polished stones, but to a lesser degree. Similarly,
when a buyer breaches a promise to pay money, it is difficult, if not
impossible, to determine the profit the promisee would have made subse-
quent to the breach had he been able to invest the money he was owed-
the value of business opportunities forgone is inherently speculative. The
longer it takes to obtain a judgment, which in New York court can take
up to three years, the greater will be the uncompensated loss suffered by
the promissee when his ability to enter into subsequent transactions is
impaired due to lack of capital.
In calculating expectation damages, courts award interest to compen-
sate the promisee for doing without the money during the pendency of
the controversy. Interest will fully compensate the promisee only if the
unavailability of funds did not affect his ability to enter into subsequent
transactions, that is, if the promisee had access to credit on reasonable
terms during the relevant time period. The typical diamond dealer does
not have ready access to capital markets or excess cash on hand. For
example, in a transaction between two non-sight holders, if the promisee
is not paid, it is unlikely during the pendency of the dispute that he will
be able to either borrow money or obtain access to the implicit capital
market at the predispute implicit interest rate.46 If the amount owed is
large, it is quite possible that he will have to suspend operations until he
is paid. In the New York diamond market, which specializes in the largest
41 Even the expert diamantaires who sit on the DDC's arbitration panel have difficulty
accurately valuing lost profit and business opportunities forgone. They are allowed to award
punitive damages, however, and usually err on the side of generously compensating the
promisee for alleged lost profit. They render their decisions quickly so as to minimize the
number of business opportunities the promisee will have to forgo when he is not paid. See
text at Section IVG infra.
I A dealer's ability to obtain credit through the industry's implicit capital market will
also be affected by the existence of a public dispute. Until a decision is rendered, the
judgment enforced, and the dealer absolved of wrongdoing, other dealers will be either
unwilling to sell to him on credit or will charge him a higher implicit interest rate on each
transaction to compensate for the perceived increase in the risk of nonpayment and the
depletion of his cash reserves. Thus, even if a court were to adjust its award of expectation
damages by the correct interest rate, the promisee would still be undercompensated; until
the controversy is resolved, the promisee will have to pay the higher implicit interest rate
in every subsequent transaction, while the court will award him interest only on the amount
of the original debt. Thus, the shortcomings in the expectation remedy are particularly acute
in an implicit capital market.
and highest quality goods, this is often the case, particularly for midsize
dealers who operate on a tight cash flow margin. Having a portion of his
capital tied up for three years while a lawsuit progresses through the New
York Courts could cause a dealer extensive financial harm that would
not be taken into acocunt in the final calculation of damages. In addition,
when the promisor's default causes the promisee to breach other con-
tracts, the promisee will suffer long-term damage to his reputation for
which he will not be compensated under standard damage measures.
One possible way to contract around some of these difficulties would
be to include a liquidated damages clause. The validity of a liquidated
damage clause, however, is often uncertain because of the elusive distinc-
tion between valid clauses that are "genuine preestimates" of the antici-
pated damages and those that are void as "penalties. ' '4 7 In a diamond
transaction, it would be particularly difficult to draft a liquidated damages
clause that a court would view as a "good faith" attempt to preestimate
damages. Often, at the time of contracting, the parties themselves are
unable to accurately preestimate damages since the actual harm suffered
by the promisee in the event of breach depends largely on business deci-
sions made after entering into the contract. For example, even if at the
time of contracting nonpayment would neither have bankrupted the prom-
isee nor caused him to default on other obligations, if he subsequently
made a large financial commitment in reliance on being paid and then
was not, he might suffer tremendous financial and reputational harm,
particularly if forced to go to court to obtain a judgment. Since at the time
of contracting the magnitude of this harm could not have been predicted,
liquidated damages clauses designed to compensate the promisee for this
type of harm would run a serious risk of being invalidated as penalties.
Furthermore, even if a valid clause could be drafted, the cost of negotiat-
ing its terms would greatly increase precontract transaction costs, thus
depriving the clause of much of its utility. 48
17 The validity of a liquidated damages clause is governed by UCC § 2-718(1), which
provides that: "[d]amages for breach by either party may be liquidated in the agreement
but only at an amount which is reasonable in the light of the anticipated or actual harm
caused by the breach. . . .A term fixing unreasonably large liquidated damages is void as
a penalty." In Equitable Lumber Corp. v. IPA Land Dev. Corp., 38 N.Y.2d 516, 381
N.Y.S.2d 459, 344 N.E.2d 391 (1976) the court held that, even if a liquidated damages
clause "satisfy[s] the test set forth in the first part of § 2-718(1), a liquidated damages
provision may nonetheless be invalidated under the last sentence of this section if it is so
unreasonably large that it serves as a penalty rather than a 'good faith' attempt to pre-
estimate damages."
I Another possibility would be to include a clause making the promisor liable for all
consequential damages suffered by the promisee. Because consequential damages can be
enormous, are highly unpredictable, and will depend largely on actions taken by the prom-
isee subsequent to the agreement, it is unlikely a businessman would agree to them.
Although the divergence between the expected cost of breach to the

promisor and the actual loss suffered by the promisee is likely to be
particularly large in the diamond industry, this divergence is present to
some extent in every commercial transaction. A suit for breach of con-
tract is a way for the promisee to control the damage he suffers; it does
not make him whole. In a now-famous study, Macaulay found that, even
among businessmen who use legally enforceable contracts, when unfore-
seeable contingencies arose, there was a tendency to renegotiate con-
tracts and settle disputes rather than resort to litigation. 49 Because ex-
pectation damages never fully compensate the promisee, all business
contracts have an implicit, extralegal term that captures the value of the
promisors' reputation.
D. Reputation Bonds as a Way of Enforcing Extralegal

ContractualCommitments
In practice, a significant portion of most commercial contracts are
backed, at least in part, by a reputation bond. What is unique about
the diamond industry is not the importance of trust and reputation in
commercial transactions, but rather the extent to which the industry is
able to use reputation/social bonds at a cost low enough to create a
system of private law enabling most transactions to be consummated and
most contracts enforced completely outside the legal system.
Types of Reputation Bonds. The typical diamond transaction involves
the posting of a reputation bond equal to the present value of the profit
on future transactions that will not take place if the promisor breaches a
contract, less his ability to cover. In practice, the value of an individual's
reputation is a function of the degree to which he possesses those attri-
butes that other dealers consider important in business relationships-
such as honesty and a record of prompt payment of debt. In the diamond
industry, reputation bonds are, in practice, the sole enforcement mecha-
nism in transactions between dealers who are not members of a bourse.
In transactions between bourse members, agreements can also be en-
forced in a proceeding before the bourse's board of arbitrators, which
has the authority to award any measure of damages it finds appropriate
and suspend or expel members for noncompliance with its judgments.
Reputation bonds, however, are the primary reason that the arbitration
tribunal's decisions are obeyed; they are essential to the bourse's ability
'9 Stewart Macaulay, Non-contractual Relations in Business: A Preliminary Study, 28

Am. Soc. Rev. 55 (1963).
to enforce its judgments. The main function of both the club and its
arbitration system is to enhance the functioning of reputation bonds.5"
Transactions between members of the same trading community also
involve the posting of a "psychic/social" bond. There are two types of
social bonds. Primary social bonds are similar to reputation bonds in that
they have a market value. When a primary social bond is sacrificed, a
dealer's ability to communicate information about his reputation and ob-
tain information about business opportunities is diminished. In contrast,
secondary social bonds may have a value to the individual on a personal
level, but their loss often will not have a direct economic effect on the
promisor. When a secondary social bond is sacrificed, a dealer may expe-
rience, "loss of opportunities for important or pleasurable associations
with others, loss of self-esteem, feelings of guilt, or an unfulfilled desire
to think of himself as trustworthy and competent." 5 Although secondary
social bonds are becoming less important in the diamond industry, ves-
tiges of their former importance remain, The Diamond Dealers Club still
functions like an old-fashioned mutual-aid society. It provides kosher
restaurants for its members. A Jewish health organization provides emer-
gency medical services, and social committees are organized by neighbor-
hood to visit sick members and their families. There is a synagogue on
the premises, and contributions to a benevolent fund are required. Group
50 In considering the theory of reputation bonds, it is important to keep in mind that the
club's ability to enforce its arbitration judgments, whether through fines, suspension, or
expulsion, depends on its ability to harness the force of a reputation bond and that the DDC
can only enforce its judgments if noncompliance results in forfeiture of a type of reputation
bond that is recognized and given value by market forces.
In the early 1980s the DDC Board of Directors exercised their authority to expel a member
from the club for making public statements that tended to cast the industry in a negative
light. They expelled Martin Rapaport for saying to the press, "diamonds, ethics, Feh! If
the devil himself showed up they would sell to him." The real reason the club wanted to
expel Rapaport, however, was that they were opposed to his price list. See note 4 supra.
They also brought an antitrust suit against him for price-fixing and asked a Jewish court to
issue an injunction barring him from any further participation in the Jewish community until
he ceased publishing the list. The attention generated by the suit led the Federal Trade
Commission (FTC) to initiate an investigation to determine if the club itself was in restraint
of trade. Although the FTC instituted a full-scale investigation, it was later dropped. Rapa-
port challenged his expulsion in court but ultimately settled with the club on undisclosed
terms and was readmitted as a member. Today Rapaport has a strong base of support at
the club: he is a member of the board of arbitrators, and his price list is an accepted fixture
in the international diamond trade. Rapaport was not expelled for breaching contracts or
failing to meet his commercial obligations; consequently the club was unable to use its
power to exclude him from the industry. The norms of the diamond industry only work
when they capture information that the market values.
51 David Charny, Nonlegal Sanctions in Commercial Relationships, 104 Harv. L. Rev.
393 (1990).
discounts on packaged family vacations are also available so that mem-

bers' families can travel together during the month that the bourse is
closed. In addition, the board of directors has the discretion to make
charitable contributions of up to 5 percent of the organization's total
annual income.
The Theory of Reputation Bonds. Reputation bonds are generally as-
sumed to be effective only within geographically concentrated, homoge-
neous groups who deal with each other in repeated transactions over
the long run. Charny has noted, however, that a reputation-bond-based,
extralegal contractual regime will function even in large scale markets so
long as "technology . . . such as computers used to monitor credit
worthiness, or mass media used in advertising, [make it possible to] con-
vey information cheaply to a large group of transactors . . . [that is]
when a thick set of informational intermediaries" exists.52 The diamond
industry is currently in transition; it is moving from a homogeneous-
group-based, extralegal contractual regime to one that relies increasingly
on information technology.
The Homogeneous Group Regime. In a given market, geographical
concentration, ethnic homogeneity, and repeat dealing may be necessary
preconditions to the emergence of a contractual regime based on reputa-
tion bonds. As the diamond industry illustrates, however, these condi-
tions are not required for the maintenance of such a system, particularly
when the system has already demonstrated itself to be preferable (Pareto
preferred) to the established legal regime.
In general, homogeneous-group-based, extralegal contractual regimes
are more likely to arise when "preexisting or gradually evolving social
relationships provide a basis for nonlegal [extralegal] commitment[s]
without large additional investments in developing a bond ... [since they
are] incrementally less costly as nonlegal [extralegal] sanctions when they
are parasitic on background habits or understandings built into the culture
in which these bonds are formed." 53 Because the diamond industry has
long been dominated by Orthodox Jews,54 it was able to take advantage
52 Id. at 419.
IId. at 423-24.
4 Jews have been involved in the diamond industry since the Middle Ages. The original
reasons for their involvement were largely fortuitous: Jews happened to live in major cities
on the diamond trade route. In two of these cities, Amsterdam and Antwerp, laws relating
to Jewish employment were quite liberal and the governments allowed them to freely enter
the diamond-cutting trade. The concentration of Jews in the industry accelerated in 1492
when Spain expelled its Jews and large numbers then fled to Amsterdam and Antwerp. For
a brief history of the Jewish involvement in the diamond trade, see Abe Shainberg, Jews,
Diamonds and History, 100 Israel Diamonds 46 (1987). The continued Jewish involvement
in the industry has also been attributed to the fact that, due to the periodic outbreaks of
of the existence of these conditions. In the past, Jews formed a cohesive,

geographically concentrated social group in the countries in which they
lived. Jewish law provided detailed substantive rules of commercial be-
havior, and the Jewish community provided an array of extralegal dispute
resolution institutions. The parallels between Jewish law and the modern
organization of the diamond industry are striking. For example, under
Jewish law, a Jew is forbidden to voluntarily go into the courts of non-
Jews to resolve commercial disputes with another Jew. Should he do so,
he is to be ridiculed and shamed.55 Jewish law also provides rules govern-
ing the making of oral contracts and lays down rules for conducting com-
mercial arbitration.56 In the diamond industry, Jewish law provided a
code of commercial fair dealing that gradually adapted to meet the indus-
try's changing needs; yet, even as the force of religious law broke down,
the system remained strong.
The stability observed in homogeneous markets can endure even if
there are occasional breakdowns in the mechanism of extralegal enforce-
anti-Semitism, Jews sought out forms of wealth that could be easily concealed, transported,
and liquidated during difficult times.
11 See Menachem Elon, ed., The Principles of Jewish Law 20-21 (1974) ("A striking
expression of the religious and national character of Jewish law is to be found in the
prohibition on litigation in the gentile courts ... to which the halakhic scholars and commu-
nal leaders attached the utmost importance .... any person transgressing the prohibition
was deemed to have reviled and blasphemed and rebelled against the Torah").
-56There are many similarities between the DDC Bylaws and Jewish law. Jewish law
requires a three man arbitration panel. In complex cases, these Jewish arbiters "generally
based their decisions on communal enactments . . . trade usages, . . . appraisal, justice,
and equity ... and at times even upon a particular branch of a foreign legal system." Id.
at 23. Jewish law also reflects a preference for the voluntary resolution of disputes. Jewish
arbitrators were given the authority to attempt to bring about conciliation (compromise)
between parties prior to rendering their decision. Jewish arbitrators were also required to
schedule hearings and render decisions promptly. Just as the DDC arbitrators are not
required to produce written opinions of their decisions, "according to talmudic halakhah
[Jewish law], a party may require the regular court to submit written reasons for its judg-
ments, but an arbitral body is not obligated to do so, even upon request." Id. at 569.
Sometimes, however, "it is considered desirable to make known the reason for a judg-
ment," and this is in fact the practice in the Israeli bourse, which publishes important
statements of principle that are used to decide novel questions. The similarity in the terms
of the substantive law is also striking. According to Jewish law "any custom adopted by
the local merchants as a mode of acquisition is valid . . . since it fulfills the principle that
the purpose of the kinyan [any formal act of acquisition] is to bring about the decision
of the parties to conclude the transaction .... some authorities even regard a handshake
as the equivalent of an oath." Id. at 209. In addition, under Jewish law, "the decision of
the parties to conclude a sale is finalized by the performance of one of the appropriate acts
of kinyan ("acquistion") by one of the parties-generally the purchaser-that the other
parties have expressed their agreement that this be done. Ownership thereupon passes,
regardless of the question of possession, since possession sometimes accompanies the pass-
ing of ownership and sometimes not. If the consideration for the sale is monetary payment,
pay the purchase price and it becomes a debt for which he is liable." Id. at 211.
ment. Sugden developed a model of exchange that demonstrates how,

under certain conditions, a market norm that normally results in coopera-
tion can be a stable, though not unique, equilibrium-even when there
appear to be incentives for individuals to be free riders and transactors
occasionally make mistakes (breach unintentionally).57 The game is an
adaptation of the classic prisoner's dilemma model in which the following
conditions hold: the benefit to player 1 of player 2 refraining from de-
fecting b must be greater than the cost to player I of refraining from
defecting himself c; the same must also be true for player 2; k , the proba-
bility that a subsequent round will be played, must be greater than b/c,
since, if this condition did not hold, the expected gain from defection will
be greater than any gain from alternative strategies.
In the context of the diamond market, these conditions seem to hold.
The probability that the transactors will have occasion to deal with one
another in the future, 4 , is quite high. In addition, many aspects of the
industry suggest that the condition that b > c will hold. For example, a
diamond dealer generally operates on a slim cash flow margin and has
trouble getting access to capital. He routinely makes business decisions
in reliance on receiving payment on a particular date. If he is not paid,
the harm he suffers can be far greater than loss of the amount of money
he is owed. Nonreceipt of payment might force him to breach a contract
with another dealer, which will in turn damage his reputation. It might
force him into insolvency and result in suspension from the club. Overall,
he might do better forgoing the benefit of opportunistic breaches and
being able to rely on receipt of payments owed.
In essence, the game relies on the familiar strategy of tit-for-tat, in
which one player (say an established dealer) agrees to comply with the
rules of the game until the other side violates them but will punish that
player by defecting from the cooperative solution if the other player has
done so in the previous round. In general, the established dealer adopts
a strategy that promises cooperation to those who cooperate and punish-
ment to those who defect. That strategy is rendered enforceable by the
large number of established dealers willing to play in accordance with the
rules of the game. These dealers take an initial position of cooperation
and signal their future behavior by bourse membership. So long as the
occasional deviations from the basic rules are met by effective punish-
ment, the game can continue indefinitely even though there is less than
perfect compliance.
Although in theory the game may be unstable since there remains a
57 Robert Sugden, The Economics of Rights, Cooperation, and Welfare (1986).

risk of defection where the gains derived from breaching a single contract
exceed the net reputational loss, in practice this is unlikely to happen
since the largest stones are usually sold at public auction rather than in
the club or private offices-not only to obtain a reliable market price,
but also to minimize the prospect of opportunistic breach.
E. The Shift toward an Information Technology-based

ContractualRegime
Although diamond dealing was one a predominantly Jewish profession,
this is no longer true. Today, the World Federation of Diamond Bourses
has twenty member bourses, many of which are located in Asia. The
industry is increasingly turning to technology to solve the problems cre-
ated by ethnic diversity and geographical separation. This shift is opposed
by older dealers accustomed to dealing primarily with friends and long-
standing business acquaintances. As younger dealers are elected to exec-
utive positions in their bourses, however, the WFDB is considering a
number of far-reaching proposals: setting up an international computer
data base with reports of arbitration judgments from all member bourses
in an attempt to foster international uniformity in trade customs and a rule
requiring that every bourse be equipped with a fax machine for rapidly
transmitting credit information. Also under consideration, although
staunchly opposed by many dealers, is the creation of an international
computer data base describing goods available for sale worldwide.
As the diamond industry has become less ethically homogeneous and
more geographically dispersed, the WFDB had encouraged the creation
of new bourses. The world federation, in this instance backed by the
Central Selling Organization and its tremendous market power, has been
able to induce dealers in many countries to set up bourses and pay their
share of the monitoring costs needed to maintain the extralegal system.
These organizations make it clear to new entrants, who are primarily
manufacturers of small stones, that their ability to secure a steady flow
of rough diamonds for their cutting centers is intimately linked to their
willingness to play by the established rules-to organize bourses, set up
arbitration systems, and submit claims filed against them to the Arbitra-
tion Board of the World Federation.
Intrabourse monitoring is an effective way of ensuring the continued
viability of a system based on reputation and trust. A bourse's ability to
attract business depends largely on the aggregate reputation of its mem-
bers for trustworthiness and fair dealing, and a bourse's economic viabil-
ity depends, in large part, on its ability to attract foreign dealers to its
trading halls. For example, at the New York Diamond Dealers Club,
25-50 percent of the transactions that take place on the premises are by
or on behalf of foreign entities or dealers. Diamond trade journals contain
many articles about the reputations of various bourses, with particularly
heavy coverage being given to new ones. If dealers in these new trading
centers want to compete in the international market, they are forced to
incur the cost of setting up a bourse and monitoring the reputations of
its members.
Intrabourse reputation monitoring, induced by competition between
bourses, is likely to be cheaper than increased monitoring by an umbrella
organization such as the world federation. Within each bourse, there is
a measure of social and ethnic homogeneity. Consequently, intrabourse
monitoring can take advantage of preexisting social relationships and
therefore be achieved at a lower cost than regulation by an outside body
that cannot take advantage of these preexisting relationships.
In general, the world federation's drive to create new bourses has suc-
ceeded in combating an additional problem associated with markets based
on social networks among homogeneous groups, namely, that "these
markets may become unstable because of free-riding potential, as outly-
ing transactors may adopt the customs of the markets without bearing
the costs of membership." 5 8 Although it may be true that, in the long
run, "markets based upon social networks are unlikely to sustain them-
selves in the face of alternative markets based on sophisticated and poten-
tially more extensive information systems,""9 the diamond industry is
currently in a state of transition; it has succeeded, at least for the time
being, in creating a system that is designed to capture the benefits of both
monitoring by small social groups (individual bourses) and monitoring
achieved through information intermediaries (institutions such as the
world federation and brokers).
Although trade practices and customs have remained largely unaffected
by the shift from a homogeneous-group-based contractual regime toward
one that is based increasingly on information technology, the change
could radically affect the economic structure of the industry. In a
homogeneous-group-based contractual regime, developing a reputation
for trustworthiness and fair dealing takes time since reputation informa-
tion is communicated solely by world of mouth and depends largely on
personal contacts. This results in high barriers to entry. 6° In contrast,
58 David Charny, Implicit Contracts 50 (unpublished manuscript, Harvard Law School,
Law and Economics Workshop 1990).
59Id.
6o In addition, new entrants, particularly in the manufacturing sector, would also face
higher capital requirements than existing market participants since their access to the im-
plicit loan market will be limited until they establish a reputation for trustworthiness. See
text at Section IVA supra.
information-technology-based regimes lower barriers to entry by reduc-

ing an individual's cost of informing others about his reputation either
directly or through information intermediaries such as Dun & Bradstreet,
Standard & Poors, and, in the retail jewelry business, the credit ratings
of the Jewelers Board of Trade.
It might be argued that an outsider with no established reputation could
overcome reputation-related barriers to entry by offering to transact using
legally enforceable contracts. If extralegal contracts are rationally pre-
ferred, however, a promisor offering a written agreement would have to
offer a much higher price to compensate the promisee for the risk and
imperfections of litigation-not only the actual cost and uncertainty of
the litigation, but also the reputational damage of being involved in a
court suit at all. More important, over a certain range of transaction
values, a legally enforceable agreement is not of great value to a party.
Even with larger transactions, the expected value of a legally enforceable
contract in the absence of information about the other party's reputa-
tion might be less than the expected value of a legally unenforceable
agreement with a person with a reputation for honesty and fair dealing.
Although, as the size of the transaction increases, the benefit of a legally
enforceable contract increases relative to the transaction costs of litiga-
tion, the amount of capital that is tied up is greater, which in turn in-
creases the opportunity cost of doing without the capital during the pen-
dency of the litigation.
F. Reputation Bonds and Economic Efficiency

The use of reputation bonds to enforce contracts is sometimes said to
be inefficient because there is no correlation between the damage suffered
by the promisee and the cost of breach to the promisor. Because the cost
of breach to the promisor is generally assumed to be large, reputation
bonds are said to induce an inefficiently high level of contractual perfor-
mance. The most common type of executory agreement in the diamond
industry, however, is exchange of goods today for a promise to pay X
dollars on a future date. Consequently, the most common type of breach
is nonpayment. On the day payment is due and the buyer has to make
the decision to perform or breach, the seller's expectancy is known with
certainty; it is X dollars. Since only money is at stake, and it is of equal
value to both parties, performance is always indicated; the extent of a
payment obligation cannot be made to turn on either party's "need" for
the money. Thus, even a legal rule that led to no breach of contract would
be efficient in the context of these transactions. This is, in fact, close to
what is observed in the market; breach of contract is rare. A rule that
leads to no breach of contract has additional benefits in the diamond

industry where sellers routinely rely on buyer's promises to pay.
In the market for polished stones, even when transactions take the
form of an exchange of executory promises, there is no such thing as
efficient breach. Although they are somewhat more difficult to value ob-
jectively, and cannot quite be bought and sold on a spot market, polished
diamonds are much like any other commodity. Rough diamonds, in con-
trast, are mere inputs (along with capital, technology, and labor) into the
production of polished diamonds. Consequently, an efficient market for
rough stones is one in which each rough stone finds its way to its highest
valued use. This outcome corresponds to the manufactuer who is willing
to pay the most for it since a manufacturer's ability to estimate the value
of the polished stones he can make from a piece of rough is critical to
his ability to earn a profit.
It might seem that, if seller (S) promises to sell a stone to manufacturer
1 (MI) for one hundred dollars and manufacturer 2 (M2) comes along
and offers two hundred dollars, in the absence of transaction costs it
makes no difference for market efficiency if S decides to sell to MI who
resells to M2, or if S sells directly to M2 and voluntarily pays M1 one
hundred dollars. Given the structure of the market for rough diamonds,
however, if S sells to M I, it is unlikely that the stone will wind up in the
hands of M2. Dealers keep their trading partners secret, particularly their
sources of rough, since a dealer's ability to operate at a profit depends,
in large part, on his network of contacts. After buying a stone that can
be cut at a profit, most manufacturers do not want to incur the search
cost of ensuring that the stone cannot be more profitably cut by another
manufacturer, not do they want it known that they have a particular type
of rough in their possession.
Given the remote possibility of resale, a rule that makes no allowance
for the prospect of efficient breach in rough diamond sales may appear
to induce too high a level of contractual performance. For a variety of
reasons, however, the magnitude of the inefficiencies introduced by this
rule is likely to be small, especially considering the increased importance
of rough brokers in the market.
One major function of a broker is to conduct an effective search for
the buyer willing to pay the highest price when the value of a stone is
uncertain. If that uncertainty exists, the original owner has every incen-
tive to hire the broker to search the market. If that has been done, then
the first purchaser for use will rightly conclude that hiring a second broker
has a very low rate of return, given the search already undertaken by the
broker for the original owner. Similarly, if the original owner did not
think it worthwhile to hire a broker for the original sale, unless circum-
stances have changed radically or the first purchaser has better informa-
tion about the market, there is no reason to suppose that he will find it
in his interest to either hire a broker or search the market himself.6 In
general, a rule requiring automatic performance will induce the optimal
amount of search by sellers before the first sale is concluded. Thus, re-
gardless of whether or not a broker was used in the original transaction,
first purchasers will rarely find it advantageous to resell even if they
search the market.
There is another reason that a rule of automatic performance does not
introduce major inefficiency in the market. The cartel has the ability to
fix the price of the rough that it sells. It also has a standard practice of
announcing the magnitude of the price increase at each sight. Together,
these two controls keep the difference between the prices that two manu-
facturers are willing to pay small relative to the aggregate benefit of
avoiding the deadweight cost of dispute resolution. As an additional bene-
fit, a high level of contractual performance in the sale of rough promotes
efficient reliance decisions such as hiring skilled diamond cutters in ad-
vance to cut and polish the rough.62 In aggregate, the magnitude of the
inefficiencies introduced through a high level of contractual performance
of executory promises to delivery rough stones is likely to be small,
particularly since contracts for future delivery of a stone are uncommon
and possession is typically transferred at the time of contracting. Thus,
while it cannot be claimed that the rule of automatic performance in
the sale of rough diamonds will always lead to the theoretically efficient
outcome, the dynamics of the market suggest that the customary solution
may well be the efficient solution when the imperfections brought on by
positive transaction costs are taken into account.
Another problem associated with the use of extralegal contracts en-
forced through reputation bonds is the cost of renegotiation, which is
6 In those situations where the first purchaser really does have superior connections for
resale, he should enter the market as a middleman. This is observed: some of the largest
manufacturers with the most extensive supply connections to sight holders, who often
purchase rough stones in large parcels rather than individually, also run very active broker-
age businesses.
62 Diamond cutters are independent contractors and are often paid by the stone. Conse-
quently, after contracting to purchase a piece of rough, a dealer will contract with a cutter.
If he does not obtain the stone and does not have other work for the cutter to do, he will
still have to pay the cutter. Furthermore, unlike many commercial contexts, at the time a
diamond contract is made, the promisee typically is unable to estimate what is reliance
expenditures will be; they will depend largely on the subsequent business opportunities that
present themselves to the promisee. For example, if he subsequently promises to pay
someone else and is unable to do so since he, himself, has not been paid, he will incur
damage to his reputation and suffer a large loss.
likely to take place quite frequently since the "sanction [imposed in the
event of breach] is much more likely substantially to undercompensate
the promisee because implicit [extralegal] contract bonds often do not
redound to the promisee's direct benefit." 63 Although the damage to the
promisor's reputation does not directly redound to the benefit of the
promisee, this problem has been largely overcome (at least with respect
to transactions between club members) by the creation of the floor com-
mittee and the board of arbitrators, both of which have the authority to
award damages.
G. The Substantive and Procedural Advantages of

Arbitration over Adjudication
In the diamond industry, arbitration has important substantive and
procedural advantages over adjudication. It enables parties to resolve
disputes and enforce judgments quickly, inexpensively, and secretly,
thereby containing damage to reputation and reducing the actual damage
suffered by the promisee in event of breach.
Unlike courts, whose award of damages is limited by either expectation
damages or a valid liquidated damages clause, the DDC bylaws allow
arbitrators to award any measure of damages they think is appropriate,
including punitive damages. They can also order one or both of the parties
to pay a fine to a third-party beneficiary such as a charity. The authority
to award punitive damages means that they can make the promisee
whole, and the authority to order payment of a fine enables them to
create a deterrent to breach contract. Since transactors know they may be
forced to pay a penalty in the event of breach, their incentive to breach
in the first place will be greatly reduced.
Although DDC arbitrators have industry expertise and sophisticated
business judgment, they are not much better than courts at valuing lost
profit or business opportunities forgone. Because arbitration hearings are
held soon after the filing of the complaint, however, and because deci-
sions are rendered and enforced shortly thereafter, the harm suffered by
the promisee, while still difficult to quantify, is minimized. The inabil-
ity of even expert dealers to accurately assess lost profit when a seller
breaches a promise to deliver a stone may be the reason that possession
is typically transferred at the time of contracting. Similarly, the difficulty
of valuing lost business opportunities when a buyer fails to pay may
account for the premium on speed: the sooner the promisee is paid, the
63 Charny, supra note 58, at 5.

fewer transactions he will be required to forgo. The bourse's ability to

resolve disputes promptly is considered so important that even if a dealer
fails to appear for an arbitration, the hearing is held and he is bound by
the panel's decision. The Floor Committee is also available during trading
hours to resolve minor disputes as soon as they arise.
In disputes other than breach of a promise to pay money or deliver a
stone, which are dealt with in the bylaws or according to well-established
custom, arbitrators' verdicts may be more accurate and predictable than
those of a court since arbitrators possess industry expertise and are per-
mitted to consider information that would be excluded in court under the
rules of evidence. If a diamond dispute were decided by a court, the
application of industry custom would be highly unpredictable: unlike a
DDC arbitrator, who can apply his own knowledge of industry custom,
a judge would have to determine the content of customary norms from
the conflicting testimony of expert witnesses. The uncertainty introduced
by a judge's need to resolve conflicting testimony would greatly reduce
the expected benefit to the promisee of having a legally enforceable con-
tract.
Under the club's bylaws, the existence of a dispute and its resolution
are kept secret so long as the arbitrators' judgment is paid promptly.
Consequently, unlike filing a claim in court, initiating an arbitration does
not affect the parties' ability to borrow or enter into implicit capital mar-
ket transactions during the pendency of the dispute, which, in turn, mini-
mizes the financial harm suffered by the promisee. The reputation damage
suffered by the promisee is reduced by the practice of keeping disputes
secret after a judgment is rendered since other transactors may view mere
participation in an arbitration as a signal that a dealer was unwilling to
renegotiate deals when unforeseen circumstances arose; they might de-
mand additional protections or charge a higher price when dealing with
him in the future.
The rapid enforcement of judgments is another advantage of DDC arbi-
tration. Unlike a court, the DDC has the ability to bring unique pressures
on the losing party to pay: it can put him out of business almost instanta-
neously by hanging his picture in the clubroom of every bourse in the
world with a notice that he failed to pay his debt. Thus, the threat of
publicity and the practice of keeping disputes secret as long as judgments
are paid gives the defendant an incentive to promptly comply with the
arbitrators' judgment. In addition, trade rules try to minimize the likeli-
hood of ajudgment-proof debtor in two ways: by making individual mem-
bers as well as the corporations they trade for liable for arbitration judg-
ments; and by providing for the expulsion of any member who files,
voluntarily or involuntarily, for personal or corporate bankruptcy in court

instead of going through the club's own bankruptcy procedure, which
requires the debtor to make 100 percent restitution to his diamond indus-
try creditors.
Although keeping this type of information about dealer behavior from
a market that works largely on reputation may slightly impair the efficient
operation of the market for reputation information, in the context of the
diamond industry's institutional structure, there are sound reasons for
this practice. Requiring arbitration judgments to be made public without
introducing additional changes in the system might result in the dissemi-
nation of information that would be difficult for the market to value accu-
rately. If only the amount of the judgment were announced, a dealer who
was ordered to pay a large judgment because there had been an honest
misunderstanding in a large transaction would suffer more reputational
damage than a dealer who had to pay a smaller judgment because of
deliberate breach or theft. Consequently, the facts of the case would have
to be released to accurately convey the relevant information to the market
if judgments were made public. Arbitrators would have to make findings
of fact and issue written opinions, which would lead to a demand for
procedural protections such as rules of evidence and more extensive dis-
covery. In time, the flexibility and informality of the system, essential to
the rapid resolution of disputes, would begin to disintegrate. Further-
more, it may be that the information most important to the reputation
market is not that a dealer has been involved in a dispute or even that
he has breached a contract, but rather that he has been prepared to either
settle disputes or abide by the judgments of the arbitral tribunal when a
third-party adjudication was necessary.
In complex cases not covered by the trade rules or industry custom,
diamond industry arbitration suffers from the same weakness as most
commercial arbitration: unpredictability. The lack of written decisions
and a tradition of stare decisis makes it difficult for market participants
to make rational breach decisions and to determine in advance the type
of sanctioned behavior. In order to increase predictability, many bourses
in the world federation have relaxed the norm of complete secrecy. Arbi-
trators publish written announcements of the principles used to decide
novel cases while keeping the parties and other identifying facts secret.
The WFDB recently proposed compiling a computer data base of these
statements of principle to promote worldwide uniformity of arbitrated
judgments and to prevent "forum shopping." They also proposed addi-
tional uniform training programs for all arbitrators. Younger WFDB offi-
cials fear that if such changes are not introduced the system will be
perceived as arbitrary and unjust, and its legitimacy may decline. Re-
cently, 64 there has been increasing pressure on the New York bourse to
relax the secrecy norm and to permit arbitrators to issue policy state-
ments in novel or complex cases-a change that would enable the indus-
try to capture the benefits of arbitration (secrecy, informality, and speed)
and litigation (the creation of precedent and stare decisis).
H. The Aggregate Efficiency of the System

The importance of international transactions suggests that concluding
transactions in accordance with a nearly uniform system of private law
has additional efficiency benefits. If a dealer is a member of any one
bourse in the world federation, he is automatically admitted to the trading
floor of all of member bourses. Most diamond dealers frequently transact
in foreign bourses. It would be wasteful for dealers to have to learn the
trade rules of different bourses and be concerned with the technicalities
of concluding legally enforceble agreements in different countries, partic-
ularly when many of these countries do not have well functioning judicia-
ries. The world federation maintains a board of arbitrators that has the
authority to settle disputes between bourses or to hear cases between
private litigants from different bourses when there is a colorable question
as to which party's bourse should hear the case. Resolving disputes
through private international arbitration also avoids complex questions
of international jurisdiction.
64 A few years ago a case arose that revived the debate over the secrecy of judgments in
the New York bourse. The Yehuda treatment is a way of altering a stone such that its flaws
become invisible to the human eye unaided by special technology. The firm that developed
this process and actually treats the stones requires those they deal with to sign an agreement
requiring disclosure of the stone's treatment to any potential buyers. Soon after the treat-
ment was introduced, but before it was widely known, a dealer sold a treated stone without
disclosing the treatment. The buyer subsequently discovered the treatment and filed a claim
against the seller. The seller defended on the grounds that he did not know or have reason
to believe that the stone had been so treated. The board of arbitrators ordered recision of
the deal and imposed a very small fine on the seller. One arbitrator wanted to write an
opinion explaining that the only reason the judgment was so small was that the treatment
was new and a dealer in exercise of ordinary care would not have been expected to ask
whether or not the stone had undergone this treatment. By the time the arbitration was
concluded, however, the treatment had become so well known that a similar defense of
ordinary care would not prevail in the future and the arbitrators intended to impose ex-
tremely heavy fines in subsequent cases. Some members of the DDC board of arbitrators
are concerned that the lack of published opinions explaining the basis of decisions gives
dealers the wrong signals about what type of behavior is sanctioned. Although cases are
officially kept secret, the industry is "like a bunch of old ladies," and in new and unusual
cases the result can rapidly become known.
1. The Importance of Reputation Bonds in the Market as a Whole

Diamond dealers consistently maintain that transactions between two
club members, between two nonmembers, and between a member and a
nonmember are conducted in exactly the same way. If the availability of
the DDC's arbitration system and enforcement mechanisms were central
to parties' ex ante decision making, the terms of the transaction (either
substantive or price) should be different when at least one party is a
nonmember. For example, a member seller who would sell a stone to
another member on thirty-day terms would be expected to charge a non-
member a higher price (or perhaps demand cash on the spot) to compen-
sate for the risk of nonpayment and the unavailability of arbitration. Deal-
ers insist, however, that no such differences exist and that they decide
who to deal with purely on the basis of the other party's reputation.
If reputation bonds are well functioning, this behavior is not surprising.
In a transaction between a member and a nonmember, the nonmember
has an incentive to keep the bargain if he wants to be admitted to the
bourse in the future. The economic benefits of bourse membership make
it actively sought after by most market participants. A member can not
only spread the word about the nonmember's wrongdoing, but he can
also object to his being accepted for club membership. In transactions
between two nonmembers, both parties have reason to worry about their
reputations. In order to obtain a steady supply of rough to run an efficient
manufacturing business, a nonmember must have a reputation of being
scrupulously trustworthy. Nonmembers know that their potential future
trading partners will inquire more deeply into their reputation before
transacting with them since they do not have the club's stamp of ap-
proval.
If dealers really did rely on arbitration to resolve most disputes, one
would expect that if it were not available more disputes would go to
court. This is not observed; litigation between two nonmembers is also
infrequent. Similarly, if reputation bonds were not strong enough to en-
force arbitration judgments, one would expect to see frequent recourse
to the courts for judicial confirmation of arbitrated judgments. This is
also not observed. Thus, it appears that the dispute resolution institutions
in the diamond industry can fairly be called extralegal: it is primarily the
fear of damage to reputation that maintains discipline in the diamond
trade, not the bourse's board of arbitrators or the procedural right to
appeal arbitrated decisions in court.
The relative importance of reputation and arbitration may now be shift-
ing, for dealers differ among themselves on the importance of arbitra-
tion's availability. Most claim that it is unimportant, but there are recent
signs to the contrary. In the early 1980s, one reason dealers gave for
leaving the newly formed Los Angeles club was that it did not provide
arbitration. Furthermore, the president of the World Federation of Dia-
mond Bourses is concerned that, as trust breaks down and dealers be-
come increasingly focused on their "rights," arbitration will come to
have a more important function. He believes that the increasing impor-
tance of arbitration and third-party dispute resolution requires more quali-
fied arbitrators and greater uniformity of decisions and is concerned that,
unless the bourses meet the challenge of providing a quick and predict-
able way of resolving disputes, the diamond industry's independence
from the legal system will slowly disintegrate.
V. ARBITRATION AND SETTLEMENT
With respect to simple disputes dealt within the bylaws or those dealt
with according to well-established custom, the decision whether to settle
or go to arbitration will depend on the usual parameters. The expected
value of the arbitration to the plaintiff will be the probability of success
on the merits, multiplied by the projected recovery, less the cost of legal
representation if represented by counsel, less (depending on the arbitra-
tor's whim) the cost of arbitration if he is made to bear it. The bylaws
provide that the plaintiff must pay the arbitration fee in the first instance
but give the arbitrators the discretion to refund the fee or order the de-
pendant to pay it. Although this fee-shifting term is a wild card, it is
bounded by the actual cost of arbitration, which is quite low relative to
the amounts at stake in the arbitration.
Conversely, the expected cost of the arbitration to the defendant is the
probability of losing multiplied by the damage award, plus legal fees if
represented by counsel, and, perhaps, the cost of the arbitration if the
arbitrators, in their discretion, order him to pay it. Models of suit and
settlement65 suggest that the closer the plaintiff and defendant's estimates
of the expected outcome of the litigation, the more likely they are to
settle. Consequently, to the extent that the required prearbitration concil-
iation proceedings shed light on the strengths and weaknesses of the
parties' arguments, they would be expected to lead to a high rate of
settlement. This is, in fact, observed: 80-85 percent of the disputes sub-
mitted to arbitration are settled during the proceeding's mandatory con-
ciliation phase.
In more complex cases-such as labor disputes, trademark infringe-
65 See Steven Shavell, Suit, Settlement, and Trial: A Theoretical Analysis under Alterna-
tive Methods for the Allocation of Legal Costs, II J. Legal Stud. 55 (1982).
ments, partnership disagreements, and the use of new techniques to make

flaws in stones invisible to the human eye-a party cannot simply be
ordered to pay the money owed or to deliver or return the stone in ques-
tion. In these cases, the arbitration panel either hears the case, or, if it
falls into one of the four categories enumerated in the bylaws,' the parties
are left free to seek a resolution of their dispute in court. When arbitrators
opt to decide complex or novel cases, however, it is difficult for the
parties to predict the rule of decision and/or the damage measure that
arbitrators will apply. Since arbitrators neither make findings of fact nor
render written opinions announcing their decisions, past decisions are a
poor predictor of future outcomes. As a consequence of both parties'
inability to predict how the arbitrators will decide complex cases, in situa-
tions where the parties do not differ greatly in their degree of risk aversion
and have similar estimates of the degree of uncertainty in the arbitrators'
decisions, they also will have an incentive to settle, just as they did
when they had near-perfect information about the rule of decision and the
damage measures that the arbitrators would employ were certain.
VI. THE EFFECT OF LEGAL INTERVENTION INTO THE EXTRALEGAL

CONTRACTUAL REGIME
In general, diamond dealers prefer to conclude agreements using extra-

legal contracts. Certain types of agreements made in the course of dia-
mond transactions, however, are routinely subject to interpretation by
the courts since they often involve the rights of third parties. Conse-
quently, these agreements often take the form of legally enforceable con-
tracts.
One example is when a bank or an insurance company is a direct
party to an agreement. Unlike individual buyers and sellers, banks and
insurance companies do not have an interest in maintaining the secrecy
norm. These institutional actors often have significant bargaining power,
particularly the banks, since in most countries a relatively small number
of banks provide most of the industry's financing.67 Consequently, banks
66 See text around note 25 infra.

67 One reason a relatively small number of banks are involved in the diamond industry
is that evaluating the worth of a stone (often used as inventory collateral) in the absence of
an objective and readily ascertainable market price requires an expertise in gemstones that
bankers seldom have. Consequently, many loan decisions are really made on the basis of
the bank's perception of the dealer's reputation in the marketplace. As an officer of the
Merchants Bank of New York (located in the middle of Forty-seventh Street) explained,
"[in terms of extending credit a bank has to look at the 3 C's-Capital, Culpability, and
Character. At our bank, we think that character is the most important C." Merchants Bank
are often able to obtain the benefit of having a legally enforceable con-
tract, such as a standard loan agreement, as well as the implicit collateral
of a reputation bond. A second example is found in transactions such
as consignments, where banks or insurance companies are not directly
involved, but where their rights may be affected later and the legal pro-
cess invoked to resolve disputes.
Consignment agreements used to be concluded orally. Under the trade
rules for consignment, title to the goods remained in the owner, and he
was entitled to get them back if they were not sold on his behalf. The
courts have been reluctant to credit arguments based on custom and
usage, however, and generally have refused to recognize the existence
of the extralegal agreement to return the goods, finding them to be the
property of the consignee. As a consequence, when a consignee goes
bankrupt, courts do not permit the consignor to recover his diamonds:
"diamonds delivered on memo to a broker or dealer usually cannot be
recouped from a trustee in bankruptcy, an assignee for the benefit of
creditors or even from a bank from whom your consignee has borrowed
money and given his bank the normal and usual security interest in his
inventory and accounts. ' ' 61 Consequently, when a dealer gives goods
on consignment, a formal consignment memorandum that satisfies the
requirements of the Uniform Commercial Code is now sometimes drawn
up to ensure that the dealer's title to the goods will be recognized by the
legal system. 69 Dealers explain that the documents are designed to serve
two distinct purposes. Between the dealers, their function is similar to
that of the bill of sale, weight slip, or cachet wrapper-they are intended
to help the dealers privately settle any disputes that may arise by clarify-
ing the terms of the original agreement. These agreements are not drawn
up in the form of legally enforceable contracts because the dealers think
the consignee will abscond with the goods. The same risk of loss would
be present in any sale for future payment (especially since consignment
Moved and Grew with Industry, N.Y. Diamonds, December 1988, at 38. Thus, although
defaulting on a loan would hurt any businessman's credit rating, the damage to a diamond
dealer is more severe since there are only a few industry lenders and banks must rely to a
greater extent on the dealers' reputation in valuing his assets.
6 S. Herman Klarsfeld, Legal Gems, N.Y. Diamonds, May 1988, at 40.
69 As the club's legal counsel recently advised dealers "the Uniform Commercial Code
(UCC) will give you protection if you adequately describe your diamonds and file a UCC-I
Financing Statement with the Secretary of State in Albany and with the register of the
county in which the consignee has an office .... This will give you a legal leg to stand on
if you unfortunately have to seek the return of your merchandise from a bank or a trustee
in bankruptcy." Id. at 63. However, due to the transactions costs of drafting and filing the
financing statement, they are used only in the largest transactions.
agreements and sales are often made between the same people), a situa-
tion in which dealers clearly prefer extralegal agreements. Legally en-
forceable contracts are sometimes used in consignments because these
transactions are often interpreted in the course of legal proceedings, and
without them courts tend to interpret the meaning of an intraindustry
consignment agreement in ways that are strongly at odds with industry
custom and the intent of the original contracting parties.
Throughout its history, the diamond business has been largely self-
regulating, operating outside the law of the state. Over the past thirty-five
years, the private dispute-resolution mechanisms in the world's diamond
bourses, combined with widespread adherence to the secrecy norm, have
succeeded in maintaining a largely extralegal contractual regime where
transactions are concluded on the basis of the dealers' reputations and
the incidence of breach is low.
Over the past decade, however, a subtle change has been taking
place-the legal system has begun to interfere with the substantive rules
used to decide arbitrated cases as well as the ways in which these deci-
sions are enforced. Under the DDC bylaws, the Board of Arbitrators can
suspend or expel a member if he does not comply with a judgment. Ever
since Martin Rapaport7" decided to break the secrecy norm, however, by
initiating the first suit against the club for any reason other than disagree-
ment with an arbitration decision, there has been a profound change in
the way the club decides cases and enforces judgments. The Rapaport
controversy has made the club much more reluctant to expel members-
it is concerned not only about the expelled member bringing suit, but it
also fears that too many expulsions will revive the Federal Trade Com-
mission's interest in its activities. At present, a member is not expelled
until the Board of Arbitrators first obtains a court order affirming its
decision. Effective sanctions may still remain, however, since the mem-
ber's picture, along with a description of the judgment that he refused to
pay will still be hung in the club room and on the trading floor of every
bourse in the world federation.
Although the DDC bylaws have always given the litigants the right to
be represented by a lawyer, prior to the Rapaport case it was uncommon.
Today, legal representation is the norm. The arbitrators feel that the
presence of lawyers has, in some measure, altered the rules of decision
they apply. The lawyers alert them to relevant parts of New York law,
and, while this law still does not supply the rule of decision, the arbitra-
tors are more conscious of the law and are increasingly reluctant to drasti-
cally depart from it, except in instances where the decisions are deeply
7o See note 50 supra.

rooted in custom or do not involve creating a new rule. Although the

Board of Arbitrators has traditionally declined jurisdiction in cases in-
volving complex statutory rights or claims that are intertwined with pend-
ing litigation, in recent years, this has become a more common practice.
The older arbitrators fear that legal interference in the diamond trade will
one day destroy the traditional way of doing business.
VII. CONCLUSION
This article has been largely devoted to offering explanations of why
the diamond industry has long relied on the extralegal enforcement of its
business norms. By a variety of reputational bonds, customary business
practices, and arbitration proceedings, the diamond industry has devel-
oped a set of rules and institutions that its participants find clearly supe-
rior to the legal system. The industry, as it has been traditionally orga-
nized, is able to make and, more important, enforce its own rules. The
market is organized to promote the low cost and rapid intraindustry dis-
semination of information about reputation, which enables it to use repu-
tation bonds to create intraindustry norms that function as a deterrent to
breach of contract and a private sanctioning system whose judgments can
almost always be enforced completely outside the legal system.
The customs and institutions in the diamond industry emerged for rea-
sons wholly unrelated to shortcomings in the legal system; yet, even as
the force of the old enforcement mechanisms of religion and secondary
social bonds began to disintegrate, a network of trading clubs, designed
to promote the dissemination of information about reputation and social-
ization among members, emerged to fill the gap. That generations of
diamond dealers have clung to nearly identical intraindustry norms in
countries with a wide variety of legal rules and institutions suggests that
the traditional rules and institutions are likely to be efficient from the
perspective of market insiders. In the United States, the traditional rules
and institutions endured over time and demonstrated their superiority to
the established legal regime.
In the diamond industry, "trust" and "reputation" have an actual mar-
ket value. As an elderly Israeli diamond dealer explained, "when I first
entered the business, the conception was that truth and trust were simply
the way to do business, and nobody decent would consider doing it differ-
ently. Although many transactions are still consummated on the basis of
trust and truthfulness, this is done because these qualities are viewed as
good for business, a way to make a profit." 7
71 Interview with author, summer 1989.

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Citation: 21 J. Legal Stud. 115 1992

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BUSINESS disputes arise in all industries, and the diamond industry is

concludes that the transaction costs of entering into legally enforceable

most intraindustry disputes are resolved cooperatively and without re-

II. AN OVERVIEW OF DIAMOND PRODUCTION AND VALUATION

A similar thesis is advanced by Robert C. Ellickson, A Hypothesis of Wealth Maximiz-

although he will sometimes negotiate in advance to sell it unopened to

III. THE MARKET FOR ROUGH AND POLISHED DIAMONDS

A. The Trading Club as a Commodities and Information Exchange

bership, a dealer must sign an agreement to submit all disputes arising

B. The Standard Transactional Paradigm

provides: "[a]ny oral offer is binding among dealers, when agreement is

14 DDC Bylaws, Art. 18 § 1.

there is generally no such thing as opportunistic breach by a seller. Al-

C. The Club's Private Arbitration System

17 DDC Arbitration Bylaws, Art. 12 § 8.

'9 Id. at Art. 12 § Ia.

conciliated, mediated, arbitrated or litigated outside the Club and/or the

Enforcing Arbitration Judgments. The DDC Bylaws provide that

27DDC Arbitration Bylaws, Art. 12 § 26.

33DDC Bylaws, Art. 20 § I Ia.

who prevailed finds it necessary to obtain a court enforcement order, the

IV. AN ECONOMIC ANALYSIS OF THE EXTRALEGAL CONTRACTUAL REGIME

A. The Reasons That Executory Agreements Are Needed

36 As a result of a confluence of factors, the diamond industry suffered a severe crash in

tant to finance diamond dealers, particularly small dealers and non-sight

(and an implicit interest rate) that a buyer would prefer to simultaneous

B. The Choice between Extralegal Agreements and

In general, the magnitude of precontract transaction costs incurred in

The diamond industry's preference for an extralegal contractual regime

expression of intention"; (2) the "cautionary or deterrent function by acting as a check

C. The Shortcomings in the American Legal System and

I A similar argument is advanced by Richard A. Epstein, Beyond Forseeability: Conse-

In practice, courts are reluctant to award compensation for lost profit

Although the divergence between the expected cost of breach to the

D. Reputation Bonds as a Way of Enforcing Extralegal

'9 Stewart Macaulay, Non-contractual Relations in Business: A Preliminary Study, 28

discounts on packaged family vacations are also available so that mem-

of the existence of these conditions. In the past, Jews formed a cohesive,

ment. Sugden developed a model of exchange that demonstrates how,

57 Robert Sugden, The Economics of Rights, Cooperation, and Welfare (1986).

E. The Shift toward an Information Technology-based

information-technology-based regimes lower barriers to entry by reduc-

F. Reputation Bonds and Economic Efficiency

leads to no breach of contract has additional benefits in the diamond

G. The Substantive and Procedural Advantages of

63 Charny, supra note 58, at 5.

fewer transactions he will be required to forgo. The bourse's ability to

voluntarily or involuntarily, for personal or corporate bankruptcy in court

H. The Aggregate Efficiency of the System

1. The Importance of Reputation Bonds in the Market as a Whole

V. ARBITRATION AND SETTLEMENT

ments, partnership disagreements, and the use of new techniques to make

VI. THE EFFECT OF LEGAL INTERVENTION INTO THE EXTRALEGAL

In general, diamond dealers prefer to conclude agreements using extra-

66 See text around note 25 infra.

7o See note 50 supra.

rooted in custom or do not involve creating a new rule. Although the

71 Interview with author, summer 1989.